Directors Of A Corporation That May Be On The Path To Insolvency

1. Introduction

   This paper is intended to give directors a better understanding of what is expected of them and what they can expect when the corporation is insolvent or on the path to insolvency.

   There may be factors that destroy a business that cannot be anticipated, but generally, corporations do not suddenly become insolvent. Bellwether symptoms present themselves to directors that can and should be recognized.

   Recent insolvencies show increased activism by affected stakeholders, such as shareholders, creditors, employees, pension funds and environmental authorities. When insolvency is a reality, these stakeholders often look to the directors, officers, advisors, lawyers and auditors to justify their actions- or inaction.

   Directors must receive timely, reliable information from management and professional advisors. It is the directors' right and obligation to insist upon the provision of this information, but they should not merely receive the information (or ignore it) without question or challenge.

2. Where are the Gatekeepers?

   I refer to a Delaware case where the court directed its comments to a corporation's lawyers and accountants. These comments have equal application to directors.

   In Lincoln Savings and Loan Association v. Wall,1 the CEO of an insolvent corporation testified that he surrounded himself with scores of accountants and lawyers to make sure that all transactions were legal.

   The Court asked:

   Where were these professionals, a number of whom are now asserting their rights under the Fifth Amendment when these clearly improper transactions were being consummated?

   Why didn't any of them speak up or disassociate themselves from the transactions?

   Where also are the outside accountants and the attorneys when these transactions were effectuated?

   What is difficult to understand is that with all the professional talent involved (both accounting and legal) why at least one professional could not have blown the whistle to stop the overreaching that took place in this case.

   If financial statements provided to the directors are positive and encouraging, the normal reaction of the directors is to compliment themselves and management. Consider, however that the financial statements may be based on incorrect or incomplete information provided by management.

   It is also possible that the financial statements, although accurate, are not fully understood by the directors. For instance, the indicated earnings may be significant, but these earnings may not represent realizable value. There may not be enough money available from the current assets to accommodate the operations of the corporation.

   Financial statements show the financial position of the corporation at a given point in time on a going concern basis. Management should regularly provide the directors with statistics that highlight the corporation's key indicators and trends so that the directors have a clear understanding of these indicators and their historical trajectory, and can more easily project trends into the future.

   As stated in Puda Coal Inc.,2 directors have a duty to think. When it is disclosed that the corporation is insolvent and had been on a path to insolvency for some time, the stakeholders will ask the directors what they did as gatekeepers to discharge their duties.

   Directors will be held accountable, more so if affected stakeholders move to access the deep pockets of the directors' insurers. Quite often, the directors' and officers' insurance may not be available or be sufficient to cover...